Automation and machine learning is driving significant advancements in a range of industries. The component of software development in R&D projects has increased significantly in the past ten years. According to Innovation Industry and Science Australia (AusIndustry), almost half of the R&D-performing entities registered R&D activities where in the field of information and computing science in 2016-17, which is more than double the number in 2005-06. Currently ICT related activities comprised 48% of all R&D expenditure claimed.
The application of the R&D tax incentive program to software development activities is becoming uncertain. AusIndustry is increasing its focus on the eligibility of software development activities, so it is worth reviewing the current landscape. Of particular note were the complete denial of the R&D claims made by Airtasker and Digivizer in 2018.
The R&D tax incentive is primarily outlined in Division 355 of the Income Tax Assessment Act 1997. The legislation identifies core R&D activities as experimental activities where specific technical issues cannot be resolved with existing knowledge or expertise but require systematic experiments and will involve the generation of new knowledge.
On 20 February 2019, AusIndustry released a “Software activities and the R&D Tax Incentive guide”. The current guidance document identifies the need for experimental activities and new knowledge for software to be eligible.
This guidance follows an earlier Tax Alert 2017/5 that was released on 20 February 2017 by AusIndustry jointly with the ATO, almost exactly two years prior. The purpose of the alert was not to change the legislation relating to the program, but to illustrate how AusIndustry and the ATO would interpret the law above in relation to software development activities. Eligibility under the R&D Tax Incentive is based on specific R&D activities rather than on entire projects. The tax alert indicated the following activities would not be eligible as core activities:
- Bug testing
- Beta testing
- System testing
- Requirements testing
- User acceptance testing
- Data mapping and data migration testing
- Testing the efficiency of different algorithms that are already known to work, and
- Testing websites in operation by measuring the number of hits.
The tax alert was amended within days to advise that in fact these types of activities could be claimed where they involve experimentation to resolve a hypothesis about specific technical issues. The change was significant, although it was communicated as a clarification rather than an amendment. This alert has largely been adopted into the latest guidance document.
AusIndustry also released a “Software guide to common errors” and broadly this recommends to:
Ensure that the software development activities are conducted in Australia, or that an advanced finding certificate has been issued in relation to those activities. Even if the contracting party is based in Australia, if that party subcontracts offshore you may have an eligibility issue if those activities are not subject to an advanced finding.
Ensure that the activities are not for the dominant purpose of developing internal administration systems. This exclusion in practice has applied to the development of HR systems, employee health management systems, equipment maintenance records management systems for internal use and customer databases. Typically if the system facilitates the delivery of services to clients and interfaces with clients then it will not be an internal administration software system.
Ensure that a thorough review has been undertaken of the project and the activities involved to determine when the R&D activities commenced and ceased. This may not be the entire software development project.
Ensure that your application for registration addresses each of the requirements of the legislation and clearly articulates the new knowledge and experimental components of the project.
Ensure that documentation supports the conduct of experimental activities.
A subsequent sector guide released in April 2022 provides further guidance. In that guide, AusIndustry indicated that claimants must show how the following activities were a part of a systematic progression of work:
- system testing
- requirements testing
- data mapping and data migration testing
- testing the efficiency of different algorithms that are already known to work
- testing websites in operation by measuring the number of hits
- digital transformation activities – transforming predominantly manual processes to digital
- upgrading technology
- routine computer and software maintenance
- data manipulation.
In this guidance, it was recognised that some routine testing activities, such as debugging (identifying and fixing errors in codes) and beta testing, can be part of a core R&D activity where they constitute part of a systematic progression of work. If you do not conduct these activities within a systematic progression of work as part of a core R&D activity, they may be supporting R&D activities. In this case, they would need to directly relate to a core R&D activity.
Areas of exposure for software projects include systems developed to conduct or execute internal management functions and the eligibility of license payments that might constitute core technology.
Prime Financial Group provide R&D tax incentive, accounting, book-keeping and tax support to innovative biotech companies. If this is something that interests you, we would be happy to speak more about how we can assist you. Please click here to get in touch.
Article Written by Simone Quin, Partner (Prime Accounting & Business Advisory)